Ethereum, cryptoeconomics, governance
wait, it’s all adverse clearing?
Last time, I argued that state debt such as US Treasuries are the real base money of the fiat system, analagous to gold under a gold standard. That argument was made in service of the thesis that unregulated free credit and currency markets maximize economic productivity and stability, and that neither free currency issuance nor lending can cause inflation in the base money. Changes in demand for base money may occur for a variety of reasons, such as a bad harvest, the collapse of a major bank, the discovery and exploitation of a major new resource deposit, and so on, but its supply can no more be increased by a commercial bank can than one can turn lead into gold.
Having established our view that in the fiat system, state debt is the base money, this article goes on to examine the fact that at the level of nations, the same principles govern money systems that govern commercial banks. At the same time, fiat and commodity money are very similar from the perspective of a credit and currency system.
wait, it’s all an information system?
Let’s explore how fiat compares to a metallic money system through the lens of trade, which is closely relevant when we consider questions of inflation and economic stability.
For the sake of our thought experiment, consider Country A which experiences a bad harvest and a subsequent increase in its demand to import wheat, and Country B, a major trading partner of Country A.
In the first version of our model, both countries use a gold standard. The value of the currency of each country is defined by how much gold it can be redeemed for per unit (or perhaps it is literally gold coinage).
Due to its bad harvest, Country A will begin to import an increased amount of wheat from Country B, paying for it in gold. Compared to a situation where no trade can occur, this will tend to:
Point one has the benefit of alleviating Country A’s wheat shortage. Point two is what people call a trade deficit, and under a gold standard will result in a drain of gold from Country A, which causes the value of gold in Country A to increase.
This means it is cheaper in gold terms for everyone else, especially those in Country B, to buy any goods or property in Country A.
As a result, so-called trade imbalances are naturally checked by the market. An imbalance in one area sends price signals that adjusts the balance elsewhere accordingly.
In our example above, citizens of Country B might begin to import an increased amount of iron produced in Country A, since it is now relatively cheaper than it was before the imbalance.
This is the money system doing what it is supposed to – helping the countless distributed independent market actors make decisions about where to apply their labor and how to expend their capital to best satisfy their desires.
Our modern fiat systems have one important difference to gold or other commodity money – instead of a common base money (gold) and domestic currencies (coins or notes), each country has its own base money, the debt issued by its sovereign, as well as currency based on it (coins, notes, etc).
If Country A has a bad wheat harvest and seeks to import more from Country B, they need to pay in Country B’s currency, BDOLLARS, not their own currency, ADOLLARS. Instead of seeing a gold drain and deflation in Country A as in the previous example, we will see ADOLLARS being sold for BDOLLARS. The result is the same, that BDOLLAR holders can buy goods and services at a discount in Country A, so they will tend to increase their imports (other than of wheat) from Country A, balancing things out.
This can be expressed either in the form of ADOLLAR/BDOLLAR price decline, increased yields on ADOLLAR denominated debt (inlation of the base money), or a combination thereof as is more likely the case. Keep in mind that the base money and origin is state debt, the currency merely one (smaller) reservoir. For comparison, there are
While the economic dynamic of a trade imbalance is the same regardless of whether money is gold or state debt, the latter could be much less liquid especially for smaller nations. As a result, we see a tendency for small countries to hold reserves of higher quality and liquidity to back their own domestic money systems, making a hybrid system.
There are major advantages to using a single money instead of different base moneys per country, most notably that a money common to many countries is necessarily more liquid and stable in its value than one used only in an isolated community. The power to print money is sweet and hard for the state to give up. Despite this, no less than eleven countries (5-6% of all countries, depending on which you count!) treat the US dollar as legal tender. For Ecuador, El Salvador, Zimbabwe, The British Virgin Islands, The Turks and Caicos, Timor and Leste, Bonaire, Micronesia, Palau, Marshall Islands, and Panama, US Treasuries are better than gold. We may as well add Ethereum to that list, as the vast majority of non-ETH capital on chain is in the form of USD stablecoins.
In both the examples above, we held that the supply of money is constant and looked only at demand side dynamics. From this perspective, fiat and gold standards are very similar, with the advantage going to whatever instrument has the most demand and liquidity. Any small country can’t hope to issue a currency more liquid than gold, let alone more liquid than US governmetn debt.
This leaves aside the critical differences in supply side dynamics. Gold and other commodity monies are extremely wasteful, much like Proof of Work. Physically ripping great chunks of rock from the ground, pulverizing them, chemical extraction processes, melting down and casting into bars, shipping around the world, and storing in secured facilities. Supply is relatively slow to respond to demand fluctuation compared to an agile central bank, yet there may be sudden supply shocks due to discovery and exploitation of major new deposits (like a reverse Bitcoin halving). Volatility and instability were major concerns of intellectuals when the gold standard was used in practice.
Fiat money, on the other hand, can have whatever supply properties the issuing state desires, so long as there is demand for its debt. Fiat currency thus enables us to consider for the first time what the optimal behavior of the money supply may be. Should money be stable in regards to purchasing power, should the supply be absolutely fixed, should it change at a fixed rate, should its supply expand and contract based on market indicators like employment rate?
That’s a topic for another day, suffice to say – US government debt is far more liquid and stable in value than gold, and there’s no theoretical reason to say commodity money is universally better than fiat or ‘designed’ money systems.
Just as banks are constrained in the amount of loans they can issue based on the amount of credit available to them, and draw upon a reserve of credit in issuing new loans, nations are constrained in the issuance of the base money by the market’s willingness to finance their debt.
The limits on a state’s ability to extract from the domestic population are political, but the market governs international trade. In the Country A and Country B examples above, nothing Country A’s government does can compel the people of Country B to sell wheat to it at less than the market price. While they may issue more units of their country’s base money without limit, it will depreciate against that of all other countries, as well as against other capital assets and commodities in the global market.
The subtitle of this piece, wait, it's all adverse clearing?, is a nod to the fact that the process by which depreciation of ADOLLAR against BDOLLAR leads to changes in the trade balance is very similar to the process of banks seeing their loans refinanced and repaid, or banknotes bought up and redeemed, if they either charge more than market rates or offer less on deposits respectively.
This breaks down when you use another country’s currency as your base money. If the United States arbitrarily increases its debt, Panamanian citizens (and DAI holders!) also see their purchasing power reduce. United States government debt represents around a third of total state debt, far above its ~13% share of the world GDP, representing the extensive international adoption of US debt as base money, and US dollars as a preferred denomination for loans and settlement. While still far short of a “world money”, it’s the closest thing by a mile.
Moral of the story: it’s the US government and the Fed, not private currency issuance or credit markets, that must be regulated to limit the damage they can inflict on the financial system. The same is true for their counterparts in other countries, though these have less of an influence over international markets and their failures more limited in their effects.
In today’s climate it is common for state actors to decry the systemic risks of stablecoins, when they themselves are by far the greatest source of volatility in the system. Central bankers blaming a market crash on commercial banks is like blaming a car crash on a child who is talking too loudly in the back seat, rather than the parent who chooses to turn around and yell at them while behind the wheel. It deserves counterargument and we should endeavor not to repeat their propaganda.
Stablecoins offer the promise of radically more transparent, responsive, scalable, and fair financial systems. They are not a creeping danger, giving the levers of money creation to maniacal operators. Believe me, if I (or any stablecoin protocol or bank) were capable of creating money from thin air, I’d not spend so much time arguing online.
Nor are they limited to a single denomination. In a future article, we’ll explore visions of what a future multipolar digital currency ecosystem could look like vs the possibility of increased dollarization on crypto rails, and how stablecoin protocols can benefit and facilitate whichever outcome the market prefers.